Externalities may take two forms. Firstly there are negative externalities. A
negative externality occurs where consumption or production of a good
generates a cost borne by someone outside of the production or consumption of
that good. A negative externality in consumption could for example be the
exhaust fumes produced by the driving of cars or the damage done to sand
dunes by tourists driving 4WD vehicles in sensitive areas. The most obvious
example of a negative externality in production is the pollution caused by many
industries.

Positive externalities occur when a benefit accrues to someone outside of the
production or consumption of a good. An example of a positive externality
might be that by individuals consuming vaccine against the influenza virus ,
those who do not vaccinate themselves receive the benefit of a reduced
prevalence of the virus in the community. When it comes to a positive
externality in production the damming of rivers for electricity is a good
example as the damming not only provides for flood mitigation for those living
downstream of the river but also provides an area for enjoying water based
recreational activities. 5

This solution may be feasible for firms but how do individuals fit in to this
scenario ? How , for example , do firms producing air pollution , merge with
the multitude of people who may be affected by its pollution. And even if we
attempt to suggest that the individuals should purchase the firm , which in
theory would internalise the effects , how is this to be effected in practical
terms. Thus again , whilst mergers suggest a theoretical solution to the problem
of externalities in many instances they are not practical solutions.

As Figure ES2 shows , the free market equilibrium will occur where demand
(D) , equals the private marginal cost (PMC) of production. This occurs at
quantity Xp. However the optimal amount of production occurs at Q* where
social marginal cost (SMC) , which takes in to account the damage (d) caused
by producing the item , equals D.

Now observe the effect of introducing a Pigouvian tax of (t) which is equal to
the marginal damage (d) of the externality at the optimal level . By
implementing the tax the firms effective supply curve is raised to become its
private marginal cost plus the tax. As a result there is a rise in the price of the
good and a contraction in demand for it. The allocatively efficient level of
production is achieved at price P1 and quantity Q*.

Pigouvian taxes therefore offer a more effective means of achieving allocative
efficiency than straight out regulatory limits or fines. Pigouvian taxes however
do still suffer from some of the same weaknesses as regulation of pollution. In
order to tax polluting firms the government or enforcing body must be able to
determine which activities produce pollution , determine which pollutants do
the harm and finally come up with some estimate on the value of the damage
being caused. Usually an estimate of these things will have to be made ,
meaning that the tax will only move us closer to the optimal position rather
than onto it. However with improving technology and greater understanding of
environmental cause and effect Pigouvian taxes may become increasing
effective in moving us towards the optimal level of production in externality
producing industries.

Firstly , the establishment and enforcement of greater private property rights by
the legal system would allow victims of negative externalities to sue the
offending party for compensation for the damage caused. For example , if
property rights to a section of river are assigned to a particular fishing club ,
then that club will be able to sue the chemical firm upstream which pollutes the
river and kills the fish stock in the fishing clubs section of the river.

The Coase Theorem suggests that " the efficient solution will be achieved
independently of who is assigned the ownership rights , so long as someone is
assigned those rights" 11 The
reasoning for this is that if the chemical firm is assigned the property rights ,
the fishing club will be prepared to pay the chemical firm an amount up to the
value of the damage being caused , to have the chemical firm reduce its output
and that at any point past X* the damage being caused exceeds the firms profits
from doing so . Hence the firm is willing to accept the payment to reduce its
output to X* . Similarly if the fishing club has the rights , it will not allow the
firm to produce past X* as the damage caused to the fishing club is greater than
any payment the firm would be willing to make. The establishment of property
rights thus creates a framework which allows bargaining and the achievement
of the socially optimal outcome.

Property rights too have a number of problems. There may be problems for
example of assigning and defining property rights and the enforcement of
property rights would most likely involve a number of significant alterations to
existing property law. There are also problems associated with the bargaining
model such as the costs of bargaining , difference of bargaining power , and
difficulty in identifying and quantifying the damage being caused. Thus whilst
property rights offer an innovative solution to the problem of externalities there
is still much work to be done in this area.